ACCA F-8

Audit Evidence

Audit Procedure & Sampling

Audit Evidence gives the guideline to Auditor to design & perform audit procedures in such a way that it enables auditors to:

- Obtain sufficient, appropriate audit evidence.- To be able to draw reasonable conclusions.- To enhance confidence of the user.

Substanstive Procedure:

Substanstive Procedure are tests to obtain audit evidence to detect material misstatements in the financial statements. They are generally of two types:

- Analytical Procedure - Tests of detail of transactions, account balances & disclosures.

ISA 330 also requires that, whatever level of substantive procedures are carried out the auditor must carry out the following procedures:

- Agree or reconcile the financial statements to the underlying accounting records.

- Examine material journal entries.- Examine other adjustments made during the course of prepearing the

financial statements.

financial statement assertions is the set of information that the preparer of financial statements ( management ) is providing to another party. Financial statements represent a very complex and interrelated set of assertions. At the most aggregate level, the financial statements include broad assertions such as "total liabilities as at 31 December are $50 million", "total revenue for the year is $9 million" and "net income for the year is $3 million".

Auditors decompose these broad assertions into a detailed set of statements referred to as management assertions, separated into three categories:

1. Transactions: o Occurrence — the transactions actually took placeo Completeness — all transactions that should have been recorded have

been recordedo Accuracy — the transactions were recorded at the appropriate

amountso Authorization — all transactions were properly authorizedo Cutoff — the transactions have been recorded in the correct

accounting periodo Classification — the transactions have been recorded in the proper

accounts2. Accounts balances:

o Existence — assets, liabilities and equity balances existo Rights and Obligations — the entity holds or controls the rights to its

assets and owes obligations to its liabilitieso Completeness — all assets, liabilities and equity balances that should

have been recorded have been recordedo Valuation and Allocation — assets, liabilities and equity balances are

included in the financial statements at appropriate amounts and any

resulting valuation or allocation adjustments are appropriately recorded.

3. Presentation and disclosure: o Occurrence — the transactions have occurredo Rights and Obligations — the transactions pertained to the entityo Completeness — all disclosures that should have been included in the

financial statements have been includedo Classification and Understandability — financial statements are

appropriately presented and described, and information in disclosures are clearly expressed.

o Accuracy and Valuation — financial and other information is disclosed fairly and at appropriate amounts.

Directorial Testing:

Substantive test are designed to discover errors or omissions

- Tests designed to discover errors : Tests should detect any overstatement & also any understatement through causes other than omission. For example: if a test is designed to ensure that sales are priced correctly, it would begin with a sales invoice selected from the sales ledger. Prices would then be checked to the official price list.

- Tests designed to discover ommisions : These tests must start from outside the accounting record & then matched back to those records. For example: to discover whether all purchases are processed properly it must have GRN (Good Received Note) & post it on Inventory A/C or purchase ledger.

Analytical Procedure:

Analytical Procedures is one of financial audit skill which help an auditor understand the client's business and changes in the business, to identify potential risk areas and to plan other audit procedures.

Analytical Procedures include comparison of financial information (data in financial statement) with

1. prior periods2. budgets3. forecasts4. similar industries and so on.

It also includes consideration of predictable relationships, such as:

1. gross profit to sales,

2. payroll costs to employees.

Example Question:

You are part of the audit team auditing the financial statements of Sweep Co, a small office supplies business, for the year ended 31 March 20X9. The company employed the following staff at the start of the financial year: 7 office and warehouse managers, 20 warehouse staff and 25 office staff.

The pay ranges for each category of staff is shown below:

Office and warehouse managers: $35-$50k per year

Warehouse and office staff: $18-$25k per year

You have been asked to audit the wages and salaries expense for the year. All staff were given a 4% pay rise in the year, backdated to the start of the year. One of the office managers left the company part-way through the year. There were two new members of warehouse staff and three new members of office staff. The expense for the year is shown in the draft income statement as $1,249,450.

Required

Using analytical procedures, perform a proof in total on the wages and salaries expense for the year.

Answer

An expectation of the charge for the year can be developed using the information provided and compared to the charge in the draft income statement to assess its reasonableness.

Managers

Based on salary range, average annual salary: $42,500

Applying the 4% rise: $44,200

Total average salary for year (i.e. 7): $309,400

Assume leaver left half-way through year: ($22,100)

Total for managers:

$287,300

Office and warehouse staff

Based on salary range, average annual salary: $21,500

Applying the 4% rise: $22,360

Total average salary for year (i.e. 40, exclude starters): $1,006,200

Assume starters started half-way through year: $55,900

Total for office and warehouse staff:

$1,062,100

Expected total expense for wages and salaries: $1,349,400

Expense per draft income statement: $1,249,450

Difference: 8%

The difference between the expected total and the expense in the draft income statement is 8%. The auditor needs to consider whether this is acceptable in light of materiality for the financial statements as a whole and performance materiality and the risk of material misstatement and whether further explanations from management may be necessary.

Accounting Estimate

An accounting estimate is an approximation of a monetary amount in the absence of a precise means of measurement.

Example of accounting estimates:

Inventory Obscolescence. Warranty Obligation. Depriciation method or useful life. Provision regarding the CV of an investment where there is uncertainty

regarding its recoverability.

Audit Sampling:

Definition

Audit sampling means the application of audit procedures to less than 100% of the items within a class of transactions or account balance such that all sampling units have an equal chance of selection, in order to assist in forming a conclusion concerning the population from which the sample is drawn [ISA 530].

3.2 Statistical vs non-statistical sampling

Statistical sampling is any approach to sampling that has the following characteristics:

(a) random selection of a sample, and

(b) use of probability theory to evaluate sample results, including measurement of sampling risk.

A sampling approach that does not have characteristics (a) and (b) is considered non- statistical sampling.

Selection of the sample

The auditor should select items for the sample with the expectation that all sampling units in the population have a chance of selection. [ISA 530]. While there are a number of selection methods, four methods commonly used are

(a) Random selection, using a computerised random number generator or random number tables.

(b) Systematic selection, in which the number of sampling units in the population is divided by the sample size, to give a sampling interval, e.g. 50, and having determined a starting point within the first 50 (preferably randomly), each 50th

sampling unit thereafter is selected. When using systematic selection, the auditor needs to ensure that the population is not structured in such a manner that the sampling interval corresponds with a particular pattern in the population;

(c) Haphazard selection, in which the auditor selects the sample without following a structured technique, but which avoids any conscious bias or predictability (e.g. avoiding difficult to locate items, or always choosing or avoiding the first or last entrieson a page). This may be an acceptable alternative to random selection provided the auditor is satisfied that the sample is not unrepresentative of the entire population; and

(d) Value weighted selection, where items are selected for testing by weighting the items in proportion to their value. It can often be efficient in substantive testing, particularly when testing for overstatement. It is also known as ‘monetary unit sampling’ (MUS). This is a technique which, when applied correctly ensures that every $1 in a population will have an equal likelihood of being selected for testing. Under MUS, material balances will be automatically selected.

3.9 Tests of detail

For tests of detail, the auditor should project monetary errors found in the sample to the population and compare this to the tolerable error.

Where an error has been established as an anomalous error, it may be excluded when projecting sample errors to the population (but still need to be considered overall in addition to the projection of the non-anomalous errors).

Where a class of transactions or account balance has been divided into strata, the error is projected for each stratum separately.

3.10 Tests of controls

For tests of controls, no explicit projection of errors is necessary since the sample error rate is also the projected rate of error for the population as a whole.

For example, if the auditor has performed tests of controls on a sample of 20 items and has found 2 deviations, this represents an error rate of 10% (2/20 x 100). The auditor must then decide if this error rate is acceptable.

11: AUDIT PROCEDURES AND SAMPLING

3.11 If the evaluation of sample results indicates that the assessment of the relevant characteristic needs to be revised, the auditor may:

(a) request management to investigate identified errors and the potential for further errors and make any necessary adjustments; and/or

(b) modify the nature, timing and extent of further audit procedures; and/or

(c) consider the effect on the auditor's report.

Lecture example 3 Preparation

You are auditing trade receivables and have obtained the following results based on your sample:

– Total value of the population $1,000,000– Number of items in the population 400– Number of items tested 20– Sample value $200,000– Error in sample $9,000

Required

(a) Assuming the errors are not anomalous ones, calculate the expected error in the population.

(b) Assuming that tolerable error was set at $40,000, explain what action should be taken.

Solution

• Ratio method extrapolation

Error rate in sample x total value in population

Computer-Assisted Audit Techniques (CAATs) which provide a means of accessing large amounts of data in a format that can provide transparency not attainable through other auditing procedures. The use of CAAT’s increases audit effectiveness, improves efficiency and decreases the audit risk.

With the use of a specialized software tool, our team can provide organizations with a unique and powerful combination of data access, analysis and integrated reporting. Using the specialized software tool our experts can access and compare enterprise data, flat files or relational databases, spreadsheets, report files, on PCs or servers, allowing the source data to remain intact for complete data quality and integrity.

NON-CURRENT ASSETES

Audit objectives for tangible non-current assets

Financial statement assertion

Existence and occurrence

– Additions represent assets acquired in the year and disposal represent assets sold or scrapped in the year.

– Recorded assets represent those in use at the year-end recorded.

Completeness

– All additions and disposals that occurred in the year have been.– Balances represent assets in use at the year-end.

Rights and obligations

– The entity has rights to the assets purchased and those recorded at the year-end.

Accuracy, classification & valuation

– Non-current assets are correctly stated at cost less accumulated depreciation.

– Additions and disposals are correctly recorded.

Assertions relating to presentation & disclosure

Disclosures relating to cost, additions and disposals, depreciation presentation and disclosure policies, useful lives and assets held under finance leases are adequate and in accordance with accounting standards (occurrence and rights and obligations, completeness, classification and understandability, accuracy and valuation)

Intangible Non-Current Asset

Key Assertions for Intangible Assets:

Goodwill:

- Check the consideration to sale agreement.- Consider whether the asset valuation is reasonable.- Check the method used for goodwill calculation & recalculate if

possible.- Review the impairment & discuss with management.

Research & Development Cost:

- Check whether it meets the criteria of IAS 38 (Research & Development Cost)

- Confirm the feasibility & viability by inspection of budgets.

- Recalculate amortization calculation. - Inspect invoices to verify expenditure incurred on R&D

expenditure.

Other Intangible Assets:

- Assess the purchased documents agreement.- If required inspect the valuation from expert professionals.- Review amortization calculation & ensure they are correct by

re-calculation.

Inventory

Assertions related to Inventory

Existance & Occurance

- Recorded Sale & Purchases reconcile with the consumption of inventory & stock on hand.

- Inventory on the financial statement physically exists.

Completeness

- All purchases & Sales are recorded.- All inventory in the year end are recorded in the financial

statement.

Accuracy, Classification & Valuation

- Costs accurately recorded in accordance with IAS.- Inventory is valued correctly (Lower of Cost & NRV).

Cut Off

- All purchases & Sales of inventory are recorded in the current period.

Presentation & Disclosure

- Inventory is properly classified in the accounts.- Disclosures relating to classification & valuation are adequate

& in accordance with accounting standard.

Audit Precedure for Inventory

Power Point Slide

Physical Inventory Count

Where inventory is material auditors shall obtain sufficient appropriate audit evidence regarding its existence & conditions by attending the physical inventory count to do the following:

- Evaluate management’s instructions & procedure for physical inventory count.

- Inspect the inventory.- Perform test counts.

Cut-Off

Auditors should consider whether management has adequate cut-off procedures. Procedures intended to ensure that movements into, within & out of inventories are properly identified & reflected in the accounting records.

Purchase invoice should be recorded only if goods where received prior to the count. A schedule of GRNs should be prepeared & items on the list should be accrued for in the accounts. Sales cut-off is generally more straight forward to achieve correctly. Invoices for good dispatched after the count should not appear in the I/S for the period.

Audit Program for Receivables

BASIC PROCEDURES     

1.     Obtain or prepare an aged trial balance of accounts receivable.

     a.     If the trial balance is prepared by the client, test the clerical accuracy. Do not test the accuracy of the aging of individual accounts until you start Step 7.

     b.     Briefly inquire of management as to steps taken to ensure the trial balance is complete, i.e., that all receivables due the company are included on the trial balance. (See also Step 10.)

     c.     Reconcile the balance to the general ledger account balance.

2.     Review the aged trial balance to determine if there are natural groups within the total population of accounts.

     3.     Select those groups that will be confirmed 100% by the use of positive confirmation letters.

     a.     Identify the accounts selected on the aged trial balance.

     b.     Review those accounts selected for confirmation with the owner/manager. If the client objects to a confirmation with a particular customer, determine if this restriction will affect your ability to accomplish the audit objectives for receivables.

     c.     Have the client prepare the positive confirmation letters reflecting, if possible, on the face of the letter or in an attached statement, the individual invoice number, invoice date, and invoice amounts that make up the customer’s balance.

     d.     Include the audit firm’s return address on all envelopes to ensure that all confirmation requests that are undeliverable by the post office are returned directly to the audit firm.

     4.     For the remaining balance that is not confirmed 100% in Step 3, determine if a sample of the accounts making up the balance should be selected for confirmation.

     a.     If sampling is appropriate, document the sampling selection process.

     b.     Repeat program Steps 3a through 3h on accounts being sampled.

Audit for Cash & Balance at Bank

The article is divided into three main sections: 1. Identifying the audit objectives applicable to cash balances. 2. Discussing considerations relevant to developing the audit plan for cash. 3. Designing and executing an audit programme for cash.

Cash audit objectives

Cash balances include cash on hand and at bank. Cash on hand includes undeposited receipts and petty cash. Cash at bank includes cash held in current and savings accounts which is available on demand. Unlike any other account balance, cash may be either an asset or a liability. The latter arises where the bank with which the entity holds an account allows the entity to write cheques in excess of the balance in the account up to an agreed limit known as an overdraft. Using the assertions described in SAS 400 (ISA 500) the audit objectives to be achieved in verifying cash balances are identified in

Table 1.

Table 1: Specific audit objectives for cash balances

Assertion Account balance audit objective

Existence Recorded cash balances exist at the balance sheet date.

CompletenessRecorded cash balances include the effects of all cash transactions that have occurred.

Rights and obligations The entity has legal title to all cash balances shown at the balance sheet date.

ValuationRecorded cash balances are realisable at the amounts stated on the balance sheet.

Presentation and disclosure

Cash balances are properly identified and classified in the balance sheet.

Lines of credit, loan guarantees and other restrictions on cash balances are appropriately disclosed.

Tests of details of balances

Substantive tests for cash balances in this category include:

1. Count cash on hand. 2. Confirm bank balances. 3. Verify bank reconciliations. 4. Obtain and use subsequent period's bank statement.

Count cash on hand

This test is often omitted as the amount of cash on hand is rarely material. If it is performed the following procedures are appropriate:

control all cash held by the entity until all funds have been counted; insist that the custodian of the cash be present throughout the count; list each item making up the balance; obtain a signed receipt from the custodian on return of the funds; ascertain that all undeposited cheques are payable to the order of the entity, either

directly or through endorsement; trace each item listed to the subsequent bank deposit.

The control of all funds is designed to prevent transfers by entity personnel of counted funds to uncounted funds. Having the custodian present and requiring his or her signature on return of the funds minimises the possibility, in the event of a shortage, of the custodian claiming that all cash was intact when released to the auditors for counting. Tracing items to the subsequent deposit tests the possibility of a teeming and lading fraud.

Confirm bank balances

It is customary for the auditors to confirm cash on deposit and loan balances at balance sheet date directly with the bank. The procedure in the UK is laid down in APB Practice Note 16, Bank Reports for Audit Purposes, based on an agreement with the British Bankers Association. Similar arrangements with the banking industry may exist in other countries. A confirmation request should be sent to all banks with which the entity had dealings at any time during the year. In addition to confirmation of the balance outstanding, the opportunity is also taken to request the bank to furnish other information such as securities held in safekeeping.

The confirming of cash on deposit provides evidence primarily as to the existence of cash at bank (because there is written acknowledgement that the balance exists), and as to rights and obligations (because the balances are in the name of the entity). The response from the bank also provides some evidence for the valuation assertion for cash at bank in

that the confirmed balance is used in arriving at the correct cash balance at the balance sheet date. Furthermore, it contributes to the completeness assertion; however, it cannot be relied on entirely because the bank confirmation usually contains a disclaimer in favour of the bank. The bank cannot be held liable if the information supplied is incomplete or inaccurate.

The confirming of overdraft and loan balances provides evidence as to:

existence, because there is written acknowledgement that the loan balance exists; rights and obligations, because the loan is a debt of the entity; valuation, because the response indicates the amount of the loan balance.

This test also contributes to the completeness assertion in the same manner as confirming deposit balances.

Verify bank reconciliations

When the entity prepares bank reconciliations on a regular basis that are expected to be reliable, the auditors will test reconciliations prepared as at balance sheet date. The test will normally include:

comparing the closing bank balance with the balance confirmed by the bank; verifying the validity of deposits in transit and outstanding cheques by,

— tracing entries in the bank statement for the last month of the fiscal year to the cash book or bank reconciliation at the beginning of the month, marking them off in the process, — identifying deposits and cheques recorded in the cash book for the last month of the fiscal year, or in the reconciliation at the beginning of that month not marked as appearing on the bank statement, and tracing them to the closing reconciliation, — clearing the bank reconciliation to ensure that all applicable outstanding deposits and outstanding cheques are marked as having been traced from the cash book and that none are fictitious.

establishing the mathematical accuracy of the reconciliation; vouching other reconciling items such as bank charges to supporting

documentation; investigating old items such as cheques outstanding for a long period of time and

unusual items; tracing outstanding cheques and deposits in transit to the subsequent period's bank

statement.

When the entity does not prepare a bank reconciliation or when control risk over entity prepared reconciliations is high (such as where it is prepared by the cashier), the auditors may prepare the bank reconciliation. When the auditors suspect possible material misstatements, the auditors may obtain the year-end bank statement directly from the bank for use in preparing the bank reconciliation and not rely on the copy of the bank

statement held by the entity. This procedure will prevent the entity from making alterations to the data to cover any misstatements.

Testing or preparing a bank reconciliation establishes the correct cash at bank balance at the balance sheet date. Thus, it is a primary source of evidence for the valuation assertion. This test also provides evidence for the existence, completeness, and rights and obligations assertions.

Obtain and use subsequent period's bank statement

The subsequent period's bank statement would normally be issued at the end of the month following the entity's financial year-end. The entity should be requested to instruct the bank to send a copy of the subsequent period's bank statement directly to the auditors. In tracing outstanding cheques the auditors may find that a prior period cheque not on the list of outstanding cheques has cleared the bank and that some of the cheques listed as outstanding have not cleared the bank. The latter may be due to delays in mailing the cheques by the entity or in depositing the cheques by the payees. The auditors should investigate any unusual circumstances.

When the total of uncleared cheques is material, it may indicate an irregularity known as window dressing. This is a deliberate attempt to enhance an entity's apparent short-term solvency. (Assume, at balance sheet date, that the entity's balances show current assets of £800,000 and current liabilities of £400,000. If £100,000 of cheques to short-term creditors have been prematurely entered, the correct totals are current assets of £900,000 and current liabilities of £500,000, which results in a 1.8:1 current ratio instead of the reported 2:1.) Window dressing is normally perpetrated by writing cheques on the last day of the financial year but not mailing them until several weeks later, when cleared funds are available at the bank to meet those cheques. If none of a sequence of cheques is presented for payment on the bank statement for more than two weeks after the balance sheet date, the auditors should make inquiries of the treasurer. Recipients do not usually delay banking cheques once received and it is normal for most cheques to clear the bank statement within a week of issue.